If you are positional trader or short-term investor then technical analysis is sufficient. Just by analysing charts you can do good trading. But a long-term investor need to have knowledge of lots of things about the company he is looking for investment. Financial ratios are the quickest tool to analyse the fundamentals of any stock. Like just by putting 10 liters of petrol in your car you can’t tell about its efficiency. But if you look at how many kilometers your car has traveled with that 10 liters and examine the kilometers per liter you can find out how efficient your car is.
The financial ratio works exactly in the same way By comparing a piece of data from one financial statement to another piece of data from another financial statement, you get the fundamental insight into the company that number alone would not provide. By knowing the financial ratio you can
What you can do with financial ratios
1. Compare several companies financials against each other
Financial ratios give you an easy method to compare companies, usually in the same industry, against each other.
2. Draw conclusions from all the financial statements
By pulling numbers from the income statement and balance sheet, you can glean insights you’d never get by reading just one of the statements.
3. Get quick insights
With just a few division problems, you can get a pretty good idea at how skilled a management team is and how well the business is operated.
Below are some popular financial ratio used by fundamental analysts
1. Return on equity
ROE measure tells you how much profit the company is generating from money entrusted to it from investors.The formula is:
Return on equity = Net income / average shareholders’ equity
Don’t assume that just because a company has a higher ROE than another, it’s a better company. A company’s ROE may be depressed because it has a large investment in assets. Those assets might give the company an edge over rivals in the long run. That’s why it’s best to compare one company’s ROE to another’s, in the same industry.
2. Return on invested capital (ROIC)
Many fundamental analysts considers ROIC as the actual ratio that represents company’s profitability. ROIC tells how much money the company makes on all the money including both debt and equity.
ROIC = (Net income – Dividends)/Total Capital
3. Debt to equity
Company’s borrow money which is generally required for new projects. But debt level should not be too high that it becomes difficult for the company to repay it in adverse situations.
The debt-to-equity ratio is one of the most basic measures of a company’s debt load. DOE compares the company’s equity to its debt. The higher the number the more debt loaded company is. DOE least is better.
DOE = Current portion of long-term debt + long-term debt / total equity × 100
4. Price to book (P/B) ratio
P/B ratio also know as price to equity ratio is used to compare a stock’s market value to its book value. It is calculated by dividing the current closing price of the stock by the latest quarter’s book value per share. Book value is the total value of the company’s assets that shareholders would theoretically receive if a company were liquidated.
P/B ratio = Stock price /( total assets – intangible liabilities and liabilities)
The higher the price-to-book ratio, the more investors are paying up for the companies’ assets. A lower P/B ratio could mean that the stock is undervalued. However, it could also mean that something is fundamentally wrong with the company.
5. Price to earning P/E ratio
This the king of all ratios that must be known to every trader and investor. PE is used to compare the valuation of different companies with each other and with the sector. The formula to calculate PE is simple
P/E ratio = stock price/ Earning per share
A lower PE than the average sector PE indicates the stock is cheaper and higher PE indicates stock is expensive. A lower PE doesn’t always shows that the stock is at attractive valuation , a lower PE could be because of bad fundamentals also. You can checkout our forum discussion on PE ratio of more about it.
6. PEG (price to earning growth) Ratio
PE ratio takes into account the current earning of company only. Ut doesn’t factors the growth rate. A company which growing at a very fast rate than the respective sector will have a higher earning and ultimately higher P/E and if it is compared with the industry P/E ratio it will look as over priced and expensive , which is not actually true. This is the reason why many analysts have started using PEG( price to earning growth) ratio. You can check out the discussion on PEG ratio to know more about it.
Abhishek is an Engineer MBA in Finance and Certified Research Analyst. He is an active trader and investor in the stock market since 2010. Follower of the philosophies of Warren Buffet and Peter Lynch in investing and trend following in trading.